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Wednesday, January 04, 2006

Unnecessary Reserve?

I was pleased to read this op-ed in yesterday's New York Times advocating the abolition of the Strategic Petroleum Reserve (SPR). I've been writing about this topic for the last two years. In general, I agree with the authors' assertion that the existence of the SPR has deterred companies from holding their own inventories, at a high cost to taxpayers and a similar cost to markets. However, I find the authors' alternative of simply letting the market handle this function inadequate. That's because the market participants they would rely on have conflicting interests--and some clear disincentives--in fulfilling this function.

Let's start with the basic question about whether any reserve is necessary, and if so, whether the amount currently in the SPR (685 million barrels)--or its recently authorized expansion to 1 billion barrels--is appropriate. As we've seen very clearly in the last few months in particular, and for the past two decades in general, the oil markets are good at reallocating supplies to make up for shortfalls due to weather, war, strikes, or accidents. This comes at a price, though. Unlike the market for airline seats, the price of the last barrel sets the price for all barrels, except where state intervention buffers this effect. The bigger the disruption and the shorter the timeframe over which adjustments must be made, the larger the magnitude of the price impact across the entire economy. In the event of a major disruption from a key supplier, such as the Saudis, the price shock could be crippling.

How much difference would 1 billion barrels make in a worst-case-scenario? As currently configured, the SPR could supply 4.4 million barrels per day (MBD)--roughly 40% of our total oil imports--for nearly eight months. Viewed in the context of a market in which a global shift in the supply/demand balance of about 2 MBD has been sufficient to double prices, 4 MBD looks very significant and adequate to all but the most extreme disruptions.

Could the same volume held in private hands have an even larger impact? Absolutely. The two biggest limitations on the SPR are the cap on its delivery rate and its inability to affect supplies in parts of the country not connected by pipeline to the Gulf Coast. Putting the SPR oil in commercial tankage near refineries all across the country might reduce its ability to respond to a local disaster, such as a Gulf Coast hurricane, but would greatly enhance its effectiveness in a national crisis by reducing the delivery time-lag and increasing the rate at which oil could be pumped out.

Unfortunately, there are two serious drawbacks to this approach, and neither was identified in the op-ed. First, oil companies currently have significant incentives to keep inventories as low as possible, consistent with smooth day-to-day operations. Accounting rules penalize them for holding high inventories, and it is expensive to manage the price-risk exposure that long-term inventory creates. Just as importantly, while oil companies like security of supply, they don't (and shouldn't) share the government's interest in mitigating price spikes. High prices bolster profits, as we've seen, and increase returns to shareholders. As the op-ed suggests, companies will only hold extra inventories if they see a clear way to profit from them.

And that's why I think the Cato Institute has provided a good opening salvo but not the whole answer. The SPR is an outdated response to the problems of the 1970s, and it carries over the regulatory mindset of that period. Its basic purpose, though, is at least as valid today, from a national perspective. The conversation should focus on the best means of executing that purpose, at the lowest cost and least disruption to the market. In my view, that means shifting the SPR oil to commercial ownership, but under carefully-crafted guidelines and with incentives that would reward companies for holding these barrels, while ensuring they would be used when needed. Tackling this would make a great energy goal for 2006.